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Public Finance ( MPA405 ). Dr. Khurrum S. Mughal. Lecture 2: Efficiency: Criterion and Government. Public Finance. Positive and Normative Economics. Positive Economics explains “what is” without making judgments about the appropriateness of “what is.”

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public finance mpa405

Public Finance (MPA405)

Dr. Khurrum S. Mughal

positive and normative economics
Positive and Normative Economics
  • Positive Economics explains “what is” without making judgments about the appropriateness of “what is.”
  • Normative Economics: designed to formulate recommendations on what should be.
normative evaluation of resource use the efficiency criterion
Normative Evaluation of Resource Use: The Efficiency Criterion
  • Pareto Optimality
  • The efficiency criterion is satisfied when resources are used over any given period of time in such a way as to make it impossible to increase the well-being of any one person without reducing the well-being of any other person.
efficiency resource use
Efficiency Resource Use

Assumptions

  • 2 inputs (capital and labor)
  • 2 outputs (food and clothing)
production functions
Production Functions

F = F(LF,KF)

C = C(LC,KC)

Where 

  • F = food production
  • C = clothing production
  • Li = labor devoted to the production of good i
  • Ki= capital devoted to the production of good i
constraints
Constraints

L = LF + LK

K = KF+ LF

productive efficiency
Productive Efficiency
  • It is not possible to reallocate inputs to alternative uses in such a manner as to increase the output of any good without reducing the output of some alternative good.
figure productive efficiency
Figure Productive Efficiency

L*

LC

0'

C

K

KC

E*

F6

Z*

F5

C1

K*

K*

F

C

Z1

F4

C2

C3

F3

C4

D

F3

C5

C6

KF

F1

LF

L

0

L*

F

efficiency condition
Efficiency Condition

MRTSFLK= MRTSCLK

  • The Marginal Rate of Technical substitution of Labor for Capital in each good are equal
figure the production possibility curve
Figure The Production-Possibility Curve

T

E

1

E

2

A

Food per Year

D

F

C

T'

0

Clothing per Year

pareto efficiency
Pareto Efficiency

Preferences on Consumption

UA= U(FA,CA)

UB = U(FB,CB)

Where

Ui = the utility of person i

Fi= food consumed by person i

Ci= clothing consumed by person i

constraints1
Constraints

F = FA+ FB

C = CA+ CB

figure efficient allocation of a given amount of food and clothing per year for two consumers
Figure Efficient Allocation of A Given Amount of Food and Clothing per Year For Two Consumers

T

CB

CB*

D

F

Food per Year

UB1

UA7

FB

UB3

UB2

UB4

E**

UA6

E*

FA*

UB5

FB*

UB6

UA5

UB7

UA3

UA4

FA

UA2

UA1

CA*

CA

C

0

T’

Clothing per Year

interpretation of efficiency criterion

Interpretation of Efficiency Criterion

Suppose we say that the “price of a unit of clothing is $1.” Then clothing is the same as “money.” We can then say that MRSACF is A’s willingness to substitute clothing for money, which is their marginal benefit of clothing, MBAC. The same is true for B. If these are equal to the MRTCF then this represents the capability of turning money into clothing as well. Thus it reflects the costs of production. Lastly if there are no other people who gain from either A or B consuming clothing or food then:

MSB = MBAC= MBBC= MSCC

efficiency and economic institutions

Efficiency and Economic Institutions

Given the conditions for a market rendering a Pareto Optimal outcome in perfect markets:

C = PKK + PLL

then production of a particular amount of a good is efficient if the slope of the production function for each good is equal to the slope of the isocost line.

figure cost minimization and productive efficiency
Figure Cost Minimization and Productive Efficiency

E

K

F = F1per Year

L

0

Capital

Labor

implications of figure
Implications of Figure
  • MRTSFLK= PL/PK
  • MRTSCLK= PL/PK
  • MRTSFLK= MRTSCLK= PL/PK
pure market economy and pareto efficiency step 1

PCMCC

PFMCF

=

Pure Market Economy and Pareto Efficiency Step 1

So far we know that PF= MCFand PC= MCCfrom perfect competition dividing one by the other we get

It can be shown that this ratio of MCs is equal to MRT

pure market economy and pareto efficiency step 2
Pure Market Economy and Pareto Efficiency Step 2
  • MCF is the amount of other resources that must be given up to produce more Food. We will denote this fact by saying:

MCF= DC.

  • It is the forgone clothing to produce more Food.
  • The same applies the other way around

MCC = DF.

pure market economy and pareto efficiency step 3

MCC DF

=

MCF DC

Pure Market Economy and Pareto Efficiency Step 3

Dividing these by each other we get:

pure market economy and pareto efficiency step 4

DF

DC

PC

MRTCF =

PF

MCC

DF

PC

=

= MRTCF =

MCF

DC

PF

Since

Pure Market Economy and Pareto Efficiency Step 4

= MRTCF

And

Then

figure 2a 5 consumer choice
Figure 2A.5 Consumer Choice

A

Food per Year

FA

CA

B

0

Clothing per Year

E

UA3

UA2

UA1

pure market economy and pareto efficiency step 5

PC

PC

A

B

MRSCF =

MRSCF =

PF

PF

Pure Market Economy and Pareto Efficiency Step 5

As just seen the slopes of the individual’s indifference curves are equal to the ratio of the prices. So

market imperfections
Market Imperfections
  • Monopoly P > MC